Emerging markets ready to step back

Your emerging-market fund might have climbed 50 percent during the last 12 months, but that doesn't mean it will be immune from the interest rate worries, housing woes and subprime mortgage angst that have tainted U.S. stocks recently.

Asia, Africa and Eastern Europe may seem a long distance from the "for sale" signs in your neighborhood and Wall Street's jitters over subprime mortgage fallout, but many analysts say they are not.

The low interest rates, and easy loan terms, that caused Americans to speculate on homes the last few years also drove an investment boom in the far corners of the globe. And with interest rates rising and lenders more wary about the ability of borrowers to repay loans, conditions are changing from the cul-de-sac to the rain forest.

Citigroup Inc. emerging-market analyst Andrew Howell warned in a recent report that the cost of borrowing money is rising in foreign markets. And because investors have pushed emerging-market stock prices to such high levels, they are not positioned to absorb the strains that higher borrowing costs can cause.

Of course, that means emerging-market funds can no longer be expected to climb 51 percent, as the average fund tracked by Lipper Inc. did the last 12 months. And Howell is suggesting they very well could fall.

The cost of capital is rising both globally and in certain emerging-market countries, Howell said. And that pressure combined with high stock prices "makes for a more challenging picture" in many emerging markets. "This is a cause for concern, especially for markets that looked stretched" with stocks priced near peak levels.

When companies need to spend more to borrow money, the costs can constrain profits the same way higher mortgage costs pressure the family budget. And because investors buy stocks so they can partake in the profits, stocks can fall if earnings don't measure up to expectations.

Howell is particularly concerned about South Africa, but less so about Russia and Israel, which have lower interest rates and more reasonable stock valuations.

Rather than moving money into emerging markets now, he would wait. Although he said it's difficult to predict when stock market turbulence will hit the developing economies, "near term we do see a vulnerability to a more serious market setback."

Howell follows markets in Africa, the Middle East and Eastern Europe, and says "interest rates in a number of countries are now considerably above their lows of the past few years. Only in Israel and Egypt are interbank rates close to recent lows."

The rising rate environment has added about 1.5 percentage points to the cost of capital, he said. And while yields and borrowing costs remain low compared to the past, "it is important to realize that the environment of 2001-05, during which monetary easing has been the dominating influence, is largely over."

Before a recent pullback, the surge in global markets -- fueled in part by easy money -- was tremendous. Since March 2003, the Morgan Stanley Capital International All Country World index has climbed about 113 percent, and emerging markets -- measured by the MSCI Emerging Market index -- have jumped about 181 percent. Since the late 1990s, emerging markets have climbed about 214 percent, far surpassing gains in developed areas of Europe, Japan and Asia-Pacific, as well as U.S. stocks.

As investors worry about rising bond yields and borrowing costs, Citigroup global strategist Robert Buckland thinks the most volatile markets will be those that have risen most since 2003 -- especially the Asia-Pacific area. Latin America is also a concern, after climbing about 80 percent during the last 12 months. Citigroup Latin America strategist Geoff Dennis has said that area could drop 15 percent to 20 percent in the near term.

Still, while the U.S. and Europe might be safer markets now, Buckland says the globe's longer-term bull market is not yet done, and investors should not pull away completely from emerging-market investments.

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Gail MarksJarvis is a Your Money columnist. Contact her at gmarksjarvis @tribune.com.